Wednesday, June 24, 2015

The end of QE and the first rate hike

Since we hit the zero lower bound, there appears to have been a basic rule of thumb regarding forward interest rates. When QE's have been in effect, the date of the initial rate hike has been stable. When QE's have not been in effect, the expected date of the first hike has generally moved forward in time. So, when QE3 was terminated while we were still firmly at the zero lower bound, one question I had was whether this pattern would continue.

So far it seems like it is continuing.

Now, there is something arbitrary about this, because it looks like the Fed will use interest on reserves to raise short term rates while there are still significant levels of excess reserves outstanding. I presume that this will cause short term rates to rise more swiftly than if they were planning on simply raising rates with open market operations. I think there would be some deflationary effects of open market operations, even at the zero lower bound, as the balance sheet would be reduced. Please correct me in the comments if I have this wrong.

In any case, even given the monetary tactics that have been proposed, which will begin with a hike in the policy rate target while there are still large quantities of excess returns, the expected date of the first hike has begun to move ahead in time as QE3 was tapered, and then finished.

In the second graph, which covers the time since the beginning of QE3, we can see that, in February of 2015, the expected rate of the first hike was around 5 months away, in June 2015. That's about when the expected date of the first rate hike was when QE3 began. The expected first rate hike is still about 5 months away - in November 2015.

Before the taper began, the expected date of the first rate hike moved around quite a bit, even though it basically ended up where it began. So, this idea isn't exactly pristine.

So, it will be interesting to see what happens over the next few months. Will the expected date of the first rate hike stabilize? Or, come December, will we be debating about whether the first hike will be coming in the summer or fall of 2016? This will be data driven, as the Fed says. One curiosity will be if Core CPI inflation moves up to around 2.5%, but this is composed of, say, 4% shelter inflation and 1.5% non-shelter inflation. Will the Fed consider this a signal to raise rates?

Of course, I see mortgage expansion as the key, and if we see mortgage expansion then I think we will be very likely to see the date of the first hike stabilize. The expected slope of rate increases is also near the low levels we saw at the beginning of QE3. (The red line in this last chart is the slope of the yield curve - the rate of future rate increases. The blue line is the expected date of the increase. It is an inverted version of the green line in the chart above.) If the expected date continues to move forward in time, I expect that the slope will continue to fall, as doubts build about the possibility of leaving ZLB. The effect of a positive surprise in interest rates will probably mostly play out in an increase in the slope of the yield curve, and this is probably still the factor to watch on a speculative short bond position. If mortgage levels continue to limp along without some sort of monetary stimulus or revolutionary change in the way we fund the housing stock, then interest rates and real GDP growth will continue to muddle along.